​Investment strategies, where investors simply invest in a fund that tracks a standard index like the S&P/ASX 200, have become increasingly popular both with institutions and private investors.

The reasons are clear – they are cheaper than most active strategies, people feel they know what they are buying and often the relevant target strategy can be hard for active managers to beat.

Not all is what it seems. This article will seek to demystify some of the hype surrounding these “passive” strategies and to highlight that while they are “passive”, it does not mean that they are without risk of disappointment.

It is important to first understand that they are typically based on the market value of companies.  The largest companies in the index are the largest ones in the portfolio. This means you can end up investing proportionately more in the largest market capitalisation and most expensive companies and can potentially also have larger exposure to industries that than is reflected in the real economy.  Reduced to its simplest a market capitalisation strategy simply keeps investing in the biggest companies regardless of their valuation. At some point this valuation may become too stretched and therefore dangerous to keep investing. A passive strategy will not care about the valuation of the largest companies but merely keep investing any subscriptions. Consequently, they may be anything but “calm and safe” as the word passive may imply?

The actual volatility, or the price swings, of an index fund may be very high especially if it has high weightings in just a few stocks.  For instance, at 31/5/2017 the 20 largest companies in the ASX300 represents 54% of the index market capitalisation. If the largest companies share common business models and an event occurs, then the share prices of all will move together.  We highlighted recently the similarity of the Australian banks and how their share prices moved together more than any other bank sector.

Passive or “index” funds have also been shown to underperform certain investment styles like Value or Growth or “Quality”– where an active fund may focus on lowly valued companies or high growth companies. Investment managers have attempted to replicate exposure to these investment styles through what are commonly known as “Smart Beta” funds.  These are becoming increasingly sourced through Exchange Traded Funds (ETFs).

While they appear to be better than simple market capitalisation weighted index approaches, they also contain risks of which investors should be aware. To keep costs down and to pass the test of being an ETF the “investment rules” that define these style portfolios are often very crude and simplistic. Using low Price to Book value ratios to select the preferred stocks in the ETF, for example, will give a Value tilt but the tilt will come without any regard to the risk of the aggregate positions. The crucial difference between an index or “smart Beta” passive approach and a portfolio is that the portfolio should be designed to maximise return while managing the risk. The standard “smart Beta” indices do not manage the risk of the $ invested but only select stocks in weights which reflect their style exposure. “Smart Beta” makes dumb portfolios.

We can explain this with an analogy. We use the analogy of shopping for food in a supermarket. Let’s say that you have to shop for food to prepare dinner. You know what dinner should look like – a sensible mix of the food groups. This sensible mix we can call a portfolio. It is optimal like a portfolio in that it will meet a number of criteria not just meet a certain tilt to price. A “smart Beta” approach to shopping for dinner would be to look for the ingredients on the basis of price. A certain $ budget would be allocated and the shopping basket (or stocks) would be selected only on the basis of price to weight of tin or price to quantity of food. You would get some ingredients that are specifically suitable for your dinner menu, but it would not be exactly what you want. A portfolio management approach would use price as an input BUT ALSO try to optimise the ratio between price paid and the amount of the specific food item to make up the dinner ingredients. The portfolio management shopper would perhaps pay up for an ingredient that was essential to diversify the other items on the menu? The portfolio management shopper should look to get a more appropriate mix of the ingredients in the basket and care about price AND relative weights to make dinner.

Like so many things in life, there is always a risk when things get too popular and so much money pours into particular strategies. Those stocks that are in indices, be they simple market cap weight indices or a crude Value or Growth fund can get pushed up too far due to the sheer weight of money going in to them, whilst those stocks lowly considered or outside these indexes or style benchmarks can become neglected and potentially undervalued.  These neglected stocks may potentially be more attractive investments going forward as is the case now – we believe.

For example, in the USA this year there has been a big focus on Growth / Momentum stocks which has meant most of the market rise can be accounted for by the movement of just a few stocks – Facebook, Amazon, Apple, Alphabet (formerly known as Google) and Netflix. The last time we saw this kind of rise was in 1999 in the USA Tech bubble.

Many of these Smart Beta strategies are currently perceived to be the new “holy grail” of investment management.  The limitations of these investment approaches may only become truly apparent after the event.  We have only to think back to the Tech boom bubble in the late 1990s and the ultimate bust of so many dot com companies in the fall out of 2000-2 to see the dangers of fashions in investing.

So, the advice is to look behind the shiny wrappers and bold claims and try to see how intelligently these strategies have been put together. What empirical evidence there is to support these approaches, and whether these trends are likely to continue?

Importantly, it is important to understand how the strategies operate and not get caught up in purely mechanical and computer driven investment approaches just because their current performance is good.  Recognise that all investment decisions involve judgement and experienced people are required to manage a portfolio, not just a set of rules.

We like to use two famous quotations when we describe our process which seeks to use quantitative or computer driven models but only with a human being in charge.

“Not everything that can be counted counts; and not everything that counts can be counted”

“I would rather be approximately right than precisely wrong”